OneMain Holdings is cheap, but not without risk (NYSE:OMF)
OneMain Financial Shares (New York Stock Exchange: OMF) have lost almost half their value over the past year as fears of recession have continued to grow. As a largely unsecured lender to middle and working class households, OMF is highly exposed to economic conditions. cycle. My analysis suggests that OMF has sufficient reserves to continue to generate substantial earnings, although earnings should normalize further. However, since other companies like Capital one (COF) also trade at very low multiples despite more diversified business, OMF does not offer the most compelling risk/reward ratio.
OneMain operates at the riskier end of the lending spectrum. Unsecured loans represent approximately 50% OMF originations with an average loan size of $8,000 and an APR of 28%, allowing for an 8-10% loss rate while remaining a profitable program. When securing loans against automobiles, the average size tends to be higher (over $12,000) with a lower rate of about 23%, but the loss rate is generally less than 6%.
These interest rates are obviously quite high, even higher than on many credit cards. Most of its clients are on the border between subprime and quasi-prime, and have on average $55-60,000 in income. Suffice it to say, many of these customers turn to OneMain because they are unable to obtain financing elsewhere. These high-risk loans provide a necessary service to people who may have emergency expenses, but it also means that OMF has customers who are more likely to default than other financial companies. This would be especially true during a downturn.
That said, for now, OMF’s business is immensely profitable. In the business second quarter, it brought in $1.68. After adjusting for one-time items, profit was $1.87, down from $2.66 a year ago. The decline in earnings was primarily due to the company provisioning $338 million for loan losses, down from $208 million a year earlier. In addition, the return on its portfolio fell from 24.2% to 23.1% due to the tightening of underwriting standards and the increase in defaults. OMF has $20 billion in loan receivables, up 10% from last year. Personal loan originations were $3.9 billion, up 2% from a year ago.
This increase in delinquencies and reserves for loan losses is the main alarm signal that worries investors. If we see the economy recover, there could be a sharp increase in defaults, leading to large losses that erode earnings and capital. In fact, as you can see, outstanding payments have steadily increased over the past year.
I think it’s important to have context here. Delinquencies decreased significantly in 2020 and 2021 as the government issued several rounds of checks in the CARES Act and US rescue plan. With this money, consumers were able to pay their debts without problems, but no one expected it to last forever. That’s why I love watching end of 2019, the delinquency rate from 30 to 89 days was 2.47%. The ratio over 90 days was 2.11%. The net imputation rate was 5.71%. So, delinquencies are now a bit higher than “normal” pre-COVID levels, but not alarmingly so. I would note that other lenders like Capital One and Synchrony (SYF) have lower delinquencies than pre-COVID today. Thus, tensions appear more in OMF’s loan portfolio, which makes sense given their riskier credit quality.
Now, it’s important to note that OneMain ran its business on the continued assumption that delinquencies would rise and that 2021 levels weren’t sustainable — they were essentially a one-time benefit that exaggerated profits. Its loan losses as a proportion of all reserves are 11%, slightly above the 10.7% it reserved at the end of 2019. This is consistent with delinquencies slightly above pre-existing levels. the COVID. Accordingly, I am less concerned that the $125 million increase in loan provisions is a sign of a spiraling increase in reserves rather than a reflection of this normalization, unless of course we see a major economic turnaround.
Additionally, even though provisions have increased, the company’s capital is stable at $3.1 billion, with earnings fully funding the $0.95 dividend and the buyback of 2.2 million shares. With this capital position, OMF has a leverage ratio of 5.6x. This compares favorably to 5.8x at the end of 2019. It also has $375 million in accessible cash and cash equivalents, as well as $6.5 billion in banking facilities that it can tap into.
Besides its high-risk clientele, I would point out two additional risks. First, unlike SYF or COF, OMF does not have a deposit base. It finances itself in the financial markets through bank facilities, securitizations and debentures. These funding costs are rising faster than deposits as the Fed raises interest rates, and there are significant maturities over the next 18 months. Combined with declining asset yields, OMF risks seeing its interest margins shrink over the next year.
Also, when OMF collateralizes its loan against an asset, it’s usually a used car, and those prices are fall now. Soaring used car prices in 2020-21 amid supply chain issues that reduced new car production was another factor contributing to OMF’s very low loan losses in the year. last. The current drop in these prices will help to continue the normalization of credit costs. As stated above, I think OMF is saving for a more normal environment, so it’s a manageable risk in my opinion.
The biggest risk for OMF would be a major recession. To that end, the fact that credit card balances are rising is often cited as a sign that consumers are feeling stressed and that delinquencies are going to get worse. In my view, this is not as concerning as it reflects the normalization of COVID distortions when fiscal stimulus allowed for a large debt repayment. As credit card balances grow, considering revenue growth over the past two years, credit card balances actually don’t look alarming. They are increasing but are below pre-COVID levels.
Since OMF tends to serve a low-income clientele, it may face increased pressure due to higher inflation. According to Atlanta Federal Reserve, individuals in the bottom quartile (1st) experience the fastest wage growth. This faster revenue growth should help offset some of the price pressure and allow consumers to continue paying down their debt.
So when we think about the earning power of the business, the most overwhelmingly negative outcomes don’t seem likely. It can be said that even if the stock has fallen a lot, the worst case is not taken into account. After all, the book value is $24.51, so OMF is still trading at a premium, given its high earnings. In terms of future earnings, for investors who agree with me, we see credit trends normalizing rather than steadily deteriorating, I’m assuming another 15% increase in credit provisions at the run rate, or a quarterly drag of around $50 million. Given the increase in funding costs, I also assume that net interest margins will contract another 50 basis points, or a cost of $25 million per quarter.
All things being equal, this would give OMF $1.30 to $1.45 in quarterly earnings power, or about $5.40 for a full year. This gives the stock an earnings multiple of 5.8x; it also means that OMF can maintain its 12% dividend yield. This is undoubtedly a cheap multiple, although it is comparable to the 6 to 6.5 times earnings multiple at which COF and SYF are trading, although both pay less as they lead a larger part of their capital towards redemptions rather than towards dividends.
Given its high cyclicality, OMF will trade at a discount multiple, but if recession fears subdued stocks, stocks could rise to 8x earnings or around $42-45, which is a 40% upside. If recession fears worsen, I would expect the book value to be around $25 to be an important support level. In a vacuum, OMF is a buy, and investors who primarily appreciate dividends or are willing to accept its riskier credit profile on OMF’s balance sheet should feel comfortable owning it. I do however believe that COF and SYF represent better investments as they offer similar earnings multiples, despite having higher quality clients and cheaper deposit funding, which is why in my portfolio I own them on OMF.